Decode Investing | Part 1 | How to make impressive returns from the stock market
There is a proven way to reliably make impressive returns from the stock market that is safe and predictable. It is called value investing, and some of the world’s most successful investors have been using it for many years. The most famous value investor is Warren Buffet, who is also one of the world’s richest people. But even before Buffet started applying value investing principles to the stock market over 60 years ago, entrepreneurs have been using similar techniques to make high returns on investments outside the stock market for thousands of years.
The principles of value investing could be applied to real estate investments, agricultural businesses, or even a lemonade stand. In fact, it is applicable to every type of business investment. The key principle of value investing is to equate buying a stock to buying the whole business outright, not just a tiny piece of it. This idea changes our entire perspective when evaluating stocks to buy, teaching us to evaluate them the same way an entrepreneur evaluates a new investment.
What is considered a high return?
Any investment that makes at least a 15% return per year is considered a high return. Reliably receiving a minimum return of 15% each year on money earned from a salaried job will turn those earnings into a fortune over time. And 15% is just the baseline; some value investors have consistently compounded money at a 50% annual rate.
Is Warren Buffet an exception?
Warren Buffet is the most notable value investor in the world, but there are many other successful value investors as well, such as Mohnish Pabrai, Phil Town, Guy Spier, Li Lu, Charlie Munger and too many others to name.
Value investing is a simple, common-sense practice; it’s how entrepreneurs have been evaluating successful investments for thousands of years. It doesn’t depend on the stock market, but it is very easily applicable to the stock market, because public companies’ financial statements are publicly available for anyone to analyze. This is not the case when investing in private businesses, as we wouldn’t be able to find the financial statements for any rental property we wanted to buy on the internet.
Why buy a stock?
As value investors, when we buy a stock, we view the investment as if we are buying the entire company, this is worth repeating. We are not buying the stock for price appreciation or dividends, but rather for all the cash surplus that the business will generate over its lifetime as an ongoing operation. In this context, cash surplus could be referred to as shareholders’ equity.
If you were to purchase a barbershop, you would be buying it for all the cash surplus it will generate during the time that you own it. The manager of the barbershop may choose to reinvest the cash surplus and open additional barbershops, which will lead to even higher profits and the generation of more free cash flow. As value investors, this growth in cash surplus generation (also known as equity) is the reason why we buy a business, whether it’s a barbershop, a rental property or a stock.
Equity (also known as book value or shareholders’ equity) is what is left for the business owner if the business were to liquidate today and stop operation. The reason why we buy a business is because we want to benefit from its growing equity. If we can estimate the business’s growth rate over the next 5 to 10 years, then we can also estimate its true value, also known as its intrinsic value.
What about stock price appreciation?
The stock price or market value of a stock is always a multiple of its equity or book value. If a stock price is below book value, it means that the stock is very cheap. This is very rare, but it can happen even to great companies.
In the short run, the stock market is a voting machine but in the long run, it is a weighing machine. — Benjamin Graham (Father of Value Investing)
The higher a business’s book value, the higher the stock price will eventually be. If we can estimate the book value (or equity) growth rate of a business we can also estimate its future stock price in 5 to 10 years.
As value investors, we are not concerned about daily fluctuations in the stock price, because we know the true value of its underlying business. If the stock price is lower than the true value, we buy more shares, and if the market value is too high, we sell the stock at a huge profit.
Only invest in wonderful businesses
A wonderful business is one that has a massive advantage over its competitors, and this competitive advantage is evident in the size of its market share. In value investing terminology, this is known as a moat. A wonderful business has a large moat that can protect it from the effects of inflation, recessions, or a black swan event.
A wonderful business also grows its shareholders’ equity at a very high rate (10% compound annual growth rate or higher).
A wonderful business has great management that is trustworthy and has the shareholders’ best interest at heart. This is evident in the company’s historical ROIC or ROE numbers. If these are good (10% or higher), it means that the management team is doing a good job reinvesting the cash generated from the business. We will go into more details about the ROIC and ROE numbers shortly.
The important thing to remember is that the evidence proving a business is wonderful must show up in the company’s key financial metrics from the previous 5–10 years. Value investors don’t rely on theory, and 10 years of good financial performance is strong evidence that a business is truly wonderful. We will discuss in detail the key financial metrics to look at when determining whether a business is wonderful.
Invest in what you love
As value investors, we don’t care about the stock market. We hate all the noise and flashing ticker symbols on the trading floors and in the financial news media. We don’t even like all this talk about money for money’s sake. We have passions, hobbies and values that are not related to money. Value investors therefore approach stock market investing the same way entrepreneurs analyze investment opportunities; we are like entrepreneurs, not Wall Street. There is a reason Warren Buffet lives in Omaha and not New York.
To find wonderful companies, start by looking at the things you love. Look for the companies that make the products you actually use or the companies that align with your values. Look for companies that are building the change you want to see in the world. Invest in your passions and values through companies that represent them.
However, don’t forget that these companies must also be wonderful businesses.
Only invest in businesses that you understand
Before you invest in a business, you should always make sure you fully understand it. If you use its products, there is a good chance you already partially understand it, but ask yourself if you understand the business side of company as well. Can you identify trends in its market and industry? Can you predict that this company will continue to grow and dominate the market for the next 10 years? If this business starts losing its competitive advantage, will you be able to recognize it based on your knowledge of its products and market?
Twenty trades to riches
There are many wonderful businesses out there, but it is difficult to find many that you understand and whose values align with yours. Value investors usually have very few stocks in their portfolio. Charlie Munger is famously known for owning only three stocks. As of this writing, I own only one stock.
Let me paraphrase something Warren Buffet said:
Imagine if you can only make twenty trades in the stock market throughout your lifetime. You would think very carefully before you make a trade because you only have twenty chances in your entire stock market career.
Twenty trades is more than enough to make you rich through value investing. I make on average about 1–2 trades a year.
The twenty-trade limit is a good mindset to adopt for value investing, because value investors don’t own a lot of stocks and also don’t trade a lot.
It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
— Charlie Munger
The best decision a value investor can make is to do nothing until the right opportunity presents itself. Then, they go in and buy aggressively.
While doing nothing in the stock market, value investors can spend time focusing on the things they love, such as family, friends and hobbies, rather than money for money’s sake.
What about diversification?
Value investing is all about knowing the true value of what you own. Diversification is evidence that the investor doesn’t truly understand the stocks in their portfolio. There are very few wonderful businesses out there, and even fewer businesses that you can understand and love. Diversification is used as a hedge against this lack of understanding.
It is also difficult to keep track of more than five businesses. For many value investors, one or two is enough. Portfolios with 20–30+ stocks usually means that the investor is hedging against a lack of knowledge; when you don’t know which ones will succeed or fail, you just buy them all.
Diversification is a protection against ignorance; it makes very little sense for those who know what they’re doing. — Warren Buffet
Concentrated Portfolios
Most successful investors bet big on one to three stocks at a time (usually just one), and they allocate all their capital to those stocks. Despite the fact that the financial planning industry recommends diversifying your portfolio with upwards of 10 securities, diversification in fact leads to lower investment returns.
What about index funds?
Buying index funds is also a hedge against ignorance. If an investor doesn’t know which stock is good or bad, then it may seem like a good idea to just buy all of them and get their average return. However, money invested in index funds could be better allocated and yield higher returns through careful value investing.
But aren’t individual stocks too volatile and risky?
A risky investment is one in a business that the investor doesn’t understand. It could also be an investment in a business with no financial records to prove their past performance. Another example is an investment in a business that has very poor past financial fundamentals.
A value investor is not worried about volatility or price fluctuations in the stock market. When the stock price is lower than the true value of the business, it is an opportunity for the value investor to buy more shares, and when the stock price is higher than the true value of the business, it’s time to sell and make a profit. If the value investor notices that the business is no longer wonderful, then it’s time to sell and move on.
To the value investor, volatility is not equal to risk. Making a bad deal, such as paying too much for a stock or buying a business that we don’t understand, is the biggest risk factor.
What if you are wrong about a stock?
In value investing, you should always buy the stock at a discount or a margin of safety price. When we calculate the true value of the stock, we discount it by 50% to get the margin of safety price. This is the price that we are willing to pay for the stock as value investors. Buying the stock at this price guarantees that we won’t lose money, even if we are wrong about the future prospects of the business.
Even wonderful businesses go on sale from time to time; we just have to be patient and wait until the stock price drops to the margin of safety price before we start buying. We have to wait for the event that will trigger stocks to go on sale for reasons that have not changed the fundamentals of the underlying business.
For example, the dot-com crash put a lot of companies on sale for no fault of their own, as did the 2008 financial crisis and the 2020 pandemic. Facebook and Google stocks dropped significantly when the government announced antitrust investigations against them, and Apple stock dropped when the U.S. government implemented trade tariffs against China during the Trump administration.
It is important to understand the company you are investing in, so that you can predict the impact an event will have on your stock’s underlying business. For example, during the 2020 pandemic, Warren Buffet announced that they sold out of all their airline positions, because they believed that the pandemic has changed the fundamentals of the airline business. He believed that airlines would need to borrow a lot of money to recover from the effects that the lockdown and travel ban had on their business.
Protecting your capital is a fundamental part of value investing. The rules of value investing are:
- Don’t lose money
- Don’t forget rule #1
Read more about how to identify a wonderful business here: https://decode-investing.medium.com/how-to-identify-a-wonderful-business-6f7afdc6a5c6
